The removal of RMB limits, coupled with the HK-Shanghai connect mark yet more steps in the financial reform journey that China seems to be beginning. Reform momentum is picking up and if the end goal for China is indeed to rebalance their economy to a more domestically consumptive model then this will require both a far more open capital account and a stronger RMB.
The recent initial signals of financial reform have been impressive and personified by the prior engine of the Chinese economy (a negative real deposit rate) moving over 1%. Add to this the consolidation of credit risk away from risky and inefficiently allocated wealth management products and the fact that (finally) Chinese credit intensity has actually started to improve and the stage is certainly set for more reforms to come.
Chinese trade strength (which has NOT been driven by trade finance) gives yet more flexibility for the Chinese to begin to rebalance and should the property market recover (initial signs that this may be beginning) then China could quickly become one of the greatest secular BUYs in recent memory. Add to this the fact that a stronger RMB should come hand in hand with an imminent RRR cut and China's current discount to the region (the highest since 1999) begins to look entirely unsustainable.
Although there are direct beneficiaries of both the HK shanghai connect and a stronger RMB the interesting thing is the implication both of these developments have for the outlook for China as a whole (particularly as the party continue to underwrite increased cross border trade with the likes of the $16bn infrastructure fund just announced).
Bank of China (OTCPK:BACHY) is both a direct beneficiary of all of these developments (only bank to be officially chosen as BOTH a clearing bank for HK - Shanghai connect AND an official RMB clearing house) and the cheapest in the sector (the Banks) that has been used to personify the Chinese economic risk environment. The entire banking sector is due a SIGNIFICANT re rating on the back of reform success and recent domestic A share moves (both in Banks and elsewhere) are showing that domestic investors are beginning to pay a premium for reform exposed sectors. In this context then, recent Bank of England commentary that the opening up of the Chinese capital account is a huge opportunity for exposed U.K. banks (HSBC (HSBC) and Stan (OTCPK:SCBFF)) and is likely to add 30% to nominal global GDP should put the potential upside for Bank of China into sharp focus.
Early stages of reform in China are impressive and happily the best exposures at this stage still remain cheap, despite recent performance.
BUY Bank of China - one of the best exposures to every area of the Chinese reform agenda in the market (Management of Capital, Liquidity, Interest Rate & Foreign Exchange currently makes up 24% of their revenue and in the 1H RMB settlement trade grew 63% YoY for the bank) while also being one of the cheapest banks in the sector.
Chinese Banks
The positive story remains for the Chinese banking sector and the 10.5% NPL ratios currently being implied by valuations looks ever further away, particularly as a quarter of property stress only lead to NPL growth increasing by 2.6% adding only 5bp to NPL ratios despite heavily constrained lending in the quarter and a property market that is beginning to recover. Should even more property stimulation become apparent (following the recent announcement of central government support for the first time since 2009), the outlook for asset quality will improve yet further.
Even in a zero growth environment warranted PB could be 125% higher than it is right now should investors get comfort that current asset stress can be digested (improvements in trade, privatising assets, stimulating through new infrastructure fund, property market recovery, RRR cut etc etc). Even aside from this, current provisioning covers the ENTIRE SML balance right now (meaning an NPL ratio 3X the current level is fully provisioned for).
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